Perspectives on Risk - Feb. 9, 2022
The Immediate Horizon; Bond Rout; Keep Things Simple; Housing Market is Ripping; Burn, Baby, Burn
The Immediate Horizon
With Russia poised to invade Ukraine, two particular risks come to the forefront of attention: cyber attacks, and the European/Global natural gas/energy market.
The first aspect of any conflict these days is to degrade the opponents information processing capabilities. Russia has a well-developed playbook here, having previously deployed it in its prior attacks on Estonia in 2007, Georgia in 2008 and Ukraine / Crimea in 2015/6. The attack this time around may be much larger, and more coordinated with military activity than past attacks.
The first cyber risk is that the attack spreads beyond the Ukraine, as the NotPetya virus did in 2017. NotPetya1 is estimated to have cost $10 billion, and affected multinational enterprises such as Merck, Cadbury, Mondel and FedEx’s European subsidiary TNT Express. Perhaps the greatest affect was on Maersk, whose total network was taken down; Maersk handled one fifth of the world’s shipping.
A greater risk is that Russia deliberately attacks non-Ukrainian Western institutions. As far back as 2018, the Cybersecurity and Infrastructure Security Agency warned that the Russian government was actively targeting the U.S. energy, nuclear, water and other critical sectors. One can easily imagine an escalation scenario where Russia invades, the West cancels the NordStream 2 pipeline2, and Russia then attacks Western energy infrastructure (on an unattributed basis) in response. Or perhaps Western financial institutions in response on financial sanctions. Interestingly, but unsurprising, European, U.S. regulators tell banks to prepare for Russian cyberattack threat.3
The second immediate issue involves the European energy sector. Crude oil largely dominated EU imports in energy products in 2021 with a share of 73% , followed by natural gas with 15%. EU countries imported 401 billion cubic meters (bcm) of natural gas. According to Eurostat, 30% of the EU's petroleum oil imports and 39% of total gas imports came from Russia in 2017. These shares have risen in recent years as Germany has decommissioned its nuclear plants following the Fukishima disaster. Europe started 2021 with gas storage only 56% full, compared with 73% a year earlier, in part because Gazprom has sold less short-term gas and hasn’t filled as much of its European storage as it normally does.
If Russia were to “turn off” its gas deliveries to Europe, which would involve breaking existing contracts and may be a step that the Russians would not want to take, Europe could have a gas deficit of ~150 bcm. The US is a significant exporter of liquified natural gas (LNG), but only a small share has historically gone to Europe.
Russia has built up substantial financial reserves, having recognized the West’s use of financial sanctions and their previous vulnerability to such tactics, and could weather a sustained period without EU energy revenue.
Gas, of course, is a fungible product, so increased demand from Europe would be initially met with a global price spike in LNG until additional production came on line, or energy substitutes were used. Clearly there would be lags. There is a material risk of an exogenous energy shock which of course would be inflationary and which would materially increase the risk of a stagflation scenario.
Wiser minds than I will understand the elasticities here (if anyone comes across something useful, please send along).
Update: It appears the market is already adjusting: Tanker Rates Turn Negative For First-Time Ever As US LNG Flocks To Europe and oil demand is up.
Now the soaring European imports from the U.S. have sent spot freight rates below zero.
Europe was the top destination for U.S. LNG exports in January, for a second month running, ahead of Asia, according to Refinitiv data cited by Reuters last week. Roughly two-thirds of U.S. LNG exports traveled to Europe last month after 61 percent of American LNG shipments went to Europe in December.
The Bond Rout
So YTD returns for the Barclays Aggregate of -3.1% now exceeds the largest annual loss since 1977.
Mostly, this has been the market pricing in the expected series of rate hikes.
The compensation for bearing duration, as measured by the term spread, as proxied by the New York Fed “ACM” (Adrian, Crump, and Moench) model is still negative. There is considerable room for the term premium top work higher as the Fed normalizes markets (the ACM term premium was last over 2.0 in December 2013, and reached 4.9% in October 2008). Interactive chart is here.
Mortgage rates/spreads have moved higher as well in anticipation of the Fed accelerating the reduction in its QE mortgage holdings.
One thing to keep in mind, and that could limit how far yields will rise, is that inflation expectations remain anchored with inflation viewed by the markets as transitory, with higher inflation at the 2 year point than at the 10 year.
Keep Things Simple
Let’s start by keeping things simple.
Is the yield curve inverted?
Are credit spreads blowing out?
Are earnings growing?
Is the economy expanding?
Is The Yield Curve Inverted? No.
The great thing about working at the Fed was that you came to know some really brilliant people. Arturo Estrella was one of them. Along with Fred Mishkin, he authored The Yield Curve as a Predictor of U.S. Recessions, which is still the seminal piece on predicting recessions. They found that:
the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill—is a valuable forecasting tool. It is simple to use and significantly outperforms other financial and macroeconomic indicators in predicting recessions two to six quarters ahead.
The NY Fed predicts the probability of a recession based on the Estrella/Mishkin metric: ~6% in January.
Some pundits are alarmed that the yield curve is close to inverting based on other measures of yield curve risk without citing evidence. Stick with the original.
Are credit spreads blowing out? No.
Some pundits are raising alarm about rising credit spreads…
Actually, spreads still look quite low.
Are earnings growing? Yes.
At this point in time, the number of companies beating EPS estimates is equal to the five-year average, but the amount by which companies are beating estimates is slightly below the five-year average. Factset S&P 500 EARNINGS SEASON UPDATE: FEBRUARY 4, 2022
However, there is a word of caution: company guidance has turned negative.
Is the economy expanding? Yes.
Real gross domestic product (GDP) increased at an annual rate of 6.9 percent in the fourth quarter of 2021, following an increase of 2.3 percent in the third quarter. The acceleration in the fourth quarter was led by an upturn in exports as well as accelerations in inventory investment and consumer spending. BEA.gov
Why Does This Matter?
The S&P500 has already had a peak-to-trough correction of ~10%. Since 1965, the average correction when we have not gone into a recession has been ~15%. The average over doubles to ~36% when the correction has occurred concurrent with a recession. Past is not per se prologue, but it helps establish a base rate for our estimates.
Housing Market is Ripping
@AltosResearch has recently been producing some excellent graphs on the state of the housing market. Housing inventory - how low can we go? on their blog is worth a read and follow.
Inventory is falling on a weekly basis
The price of newly-listed homes continues to rise rapidly
27% of houses are listed and go to contract in the same week!
And inventory levels are low
Burn, Baby, Burn
Note the date.
The insurance industry has been wrestling with elevated wildfire risk for a number of years now. Things aren’t getting any better.
The number of fires is up, already approaching September levels (should be down during the wet season).
The U.S. Department of Justice ultimately indicted six Russian GRU officers as responsible for the damage caused by NotPetya.
Russia and Europe have been pushing forward with a new pipeline, NordStream 2, that will increase the potential gas deliveries from Russia by ~50 billion cubic meters of gas a year and sidesteps Ukraine and Poland. The pipeline has been completed and filled with gas but is not operating yet pending approval by Germany’s utility regulators and the European Commission.
In a related development, it appears that a single hacker has been able to take down N. Korea’s external internet connections. North Korea Hacked Him. So He Took Down Its Internet.
“… responsibility for North Korea's ongoing internet outages doesn't lie with US Cyber Command or any other state-sponsored hacking agency. In fact, it was the work of one American man in a T-shirt, pajama pants, and slippers, sitting in his living room night after night, watching Alien movies and eating spicy corn snacks—and periodically walking over to his home office to check on the progress of the programs he was running to disrupt the internet of an entire country.”